It is understandable why there is bemoaning of only partial adoption by the U.S. Securities and Exchange Commission (SEC) of mandates for publicly registered U.S. companies to disclose how their operations and financial performance are affected by the firms’ emissions of greenhouse gases.
After all, compared to our economically advanced cohorts, U.S. public policy is a laggard in taking onboard commitments requiring firms in America to systematically and regularly disclose actions undertaken and the outcomes of such actions to enhance sustainability.
The 3-2 vote by the SEC in March to approve a subset of such requirements for its covered firms came nearly two years after it proposed a three-tier set of climate disclosure rules and reviewing more than 24,000-plus comments.
As a professional who has been toiling on sustainability policy and institutions both domestically and globally for decades—long before it became so fashionable—as well as an expert on corporate governance and the structuring of incentives that dictate modern business operations across the world, the huge outcry over the SEC’s unwillingness to approve the full set of disclosure mandates at this juncture is, on balance, exaggerated.
The pause in their approval is warranted to ensure the conceptual underpinnings of any such mandates are actually consistent with the increasing complexity of the structure and functioning of U.S. firms, whether operating at home or abroad.
This is key not only to guard against the SEC inadvertently inhibiting incentives for sound business investments today, including in sustainability, but also the incentives that drive prospective, long-run business and investment decisions that foster further innovation—whether in sustainability or in other critical areas—as well as job creation, and enhanced competitiveness as the dynamics of our global economy evolve.
Lest we forget, it is the SEC’s quarterly financial reporting requirements that have had, and still have, a pernicious impact on driving many U.S. firms’ preoccupation with short-term performance while distorting and blunting incentives for such businesses to operate guided by longer term time horizons.
What The SEC Approved and Didn’t Approve
The SEC approved ESG disclosure mandates for publicly registered U.S. firms’ directly (internally) produced—Scope 1—greenhouse gas emissions: those emitted, for example, on the factory floor by a chemical company operating its plastic injection mold machines.
At the same time, the SEC passed mandates for disclosure of Scope 2 emissions—those generated indirectly as a result of firms’ “consumption” of inputs they procure from external entities.
For example, greenhouse gases released as a by-product of an agricultural company’s operations of its oil-fired boilers for heat generation in its workspace, where the oil is procured through a fuel dealer.
In contrast, the SEC could not reach agreement—at this juncture—on rules requiring the firms it regulates to disclose “Scope 3” emissions: those emanating within a business’ successive (vertical) “stages of production” that are generated internally by the firm in question.
Think of the agricultural firm above using a portion of its own crops—the vast majority of which is sold to food processors—as feedstock for its boilers to produce heat. Rather than engaging in an arms-length market transaction to purchase fuel from a third party, the firm internalizes part of its supply chain.
The core dilemma for assessing SCOPE 3 emissions is, in essence, how to accurately classify and account for sources of emissions in settings where there is vertical integration and thus supply chains are internalized. In essence, cases where bona fide arms-length, market transactions are not utilized in business’ operations, and the contours of ownership and control and property rights are ill-defined.
Businesses’ Decisions Regarding Vertical Integration and Supply Chain Management
As someone whose career has focused on businesses’ vertical integration and supply chain strategies, decision-making, and operations across numerous industry sectors and/or geographies, the extent, definition and nature of such integration and the way supply chains are managed—whether they are inhouse or rely on external transactions with third parties—are not always clear-cut.
To simplify matters, many analysts assessing the extent of a firm’s degree of vertical integration focus on the question of whether a firm “makes or buys” certain inputs or finished outputs at particular “stages of production.”
“Makes” signifies vertical integration—whether “upstream,” where a firm produces its own inputs internally, or “downstream,” where a firm finalizes its products to bring to market. In essence, a firm that is fully vertically integrated has internalized its supply chain.
“Buys” connotes no vertical integration: whether “upstream,” where a firm relies on “arms-length” market-based transactions to buy inputs from suppliers or “downstream,” where a firm sells at “arms-length” its finalized outputs to end-users/customers.
There are, of course, many reasons and tradeoffs firms consider as to the degree to which they engage in vertical integration, whether as a means to ensure greater security/control, higher quality, or lower production costs of the supply of inputs and/or the distribution/sale of outputs.
Needless to say, there are significant tradeoffs at play here. Usually, the degree of vertical integration chosen by a firm is one that maximizes business resiliency, flexibility and/or control of the supply of various inputs or the distribution of outputs and achieves reductions in overall costs.
(Whether vertical integration (upstream or downstream) also affords firms the ability to exercise market power over rivals and suppliers or customers is a different matter—one that has been the focus of antitrust and other public policy debates for decades.)
Complexity of Risks of Inaccurate Scope 3 Emissions Disclosures
The routine practice of vertical integration and/or internalized portions of supply chains, can present complex challenges for firms to make economically meaningful, credible Scope 3 disclosures.
With the absence of open market transactions and clearly defined property rights up and down the vertical chain, the risks of double-counting or undercounting emissions on a business-by-business are great. Indeed, it will likely lead to distorted comparisons of disclosures across firms that differ significantly in terms of the degree of vertical integration.
Scope 3 disclosure estimates made by an entity the “occupies” the “middle” of a supply chain are unlikely to be as accurate or meaningful for the purposes at hand in contrast to what wholly upstream suppliers or wholly downstream users themselves can estimate.
While the intent behind the Scope 3 framework is laudable, it would seem its workability is challenging in light of how modern industries are structured and function. While businesses were, and are being consulted in the drafting of such measures, while perhaps clear in theory, in practice they are more complex than might meet the eye.
What Should Be On The Agenda To Address The Scope 3 Disclosure Challenge?
Based on past experience, the most effective practice of policy-making in new and complex areas of regulation more often than not involves an iterative process of policy design, implementation and assessment of outcomes.
To this end, should Scope 3 measures be scrapped? Not entirely. They should be put on hold—which is, of course, their current status. In this regard, there’s something to be said for the SEC moving in phases, by focusing initially on Scope 1 and Scope 2 disclosures.
The point also should be made that as important as ESG disclosures may be, without taking anything away from such an exercise, it also important to keep our eyes on the ball: The information generated through, and the resources devoted to disclosure, are not wholly reflective of businesses’ operational decisions and outcomes that enhance sustainability. In my view, as I’ve stated earlier in this space, it is those actions that should be in prime focus.
To put it baldly, disclosure is a retroactive, static exercise. It simply cannot provide a contemporaneous, dynamic view of sustainability practices and their effects. To this end, the over-arching objective should be a set of systemic policy tools that both assess business sustainability decisions made today—prior to their implementation—and then assessing actual outcomes to help better orient policy to achieve the most consequential targets.
